Ratio Back Spreads: A low-cost trading strategy amid geopolitical tensions

##Shubham Agarwal##

Options are the best instruments to trade when there are uncertain times. They have the ability to give us a lot of returns if we go right and restrict our losses just to the premium paid in case we are wrong.

However, when these uncertainties are at their peak, it becomes difficult to make money with options as well. As the expected volatility and tensions increase in the market, the option premium also increases. About a month back when these tensions were not around the same option trading at 250 now was trading at 150.

##There are two problems due to this:##

1. This reduces the return on our investments due to higher entry price. What we made by investing 150 we will make same after investing 250.

2. If the tensions, go away the same option without any reason will fall back to 150. So, we trade by buying a Call betting on the end of war and better times. What ends up happening is that tension related rise in Call go down as the war tensions are also gone. Now, out of what we make by being right on direction, we end up losing a lot of it due to this drop in premium due to drop in tension.

To counter this, we should do a strategy that will help us make money by being right in directional call during volatility as well as reduce loss on being no matter how wrong we are. The strategy is called Ratio Back Spread.

##Strategy Construction:##

##For Bullish Trades:##

Sell 1 Lot Call (Strike = Close to Current Price)

Buy 2 Lots Calls (Strike = 2 Steps Higher than the Current Price)

##For Bearish Trades##

Sell 1 Lot Put (Strike = Close to Current Price)

Buy 2 Lots Puts (Strike = 2 Steps Lower than the Current Price)

Cost: Net Premium we pay is the initial cost and it is very small compared to Single Call Buy

##Return Analysis:##

With 2 Option Buy vs One Sell, we will make money in Bullish as well as Bearish Trade. The money may not be same as Buying a single Call/Put but we will definitely make money if there is a Big Move Upwards in Bullish or Downward in Bearish Trade.

##Risk Analysis:##

In case we did a Bullish Back Ratio Spread, the risk is that the stock goes down by 10 percent instead of going up by 10 percent. Now, in case of big down move (remember it is time of Big Volatility), all the options will be close to zero. So, we can not lose more than the tiny premium paid.

Maximum loss in this strategy however is not the Net Premium paid. Maximum loss is difference between the Bought and Sold Strikes + Net Premium Paid. This is big dent.

So, for this strategy to perform better than any other, we must take care that this maximum loss scenario does not come. That can be achieved by:

1. Making Sure that we do not Hold the position for more than 2-3 sessions

2. Making sure that there at least 6-7 sessions left for Expiry

So, keeping this in mind if the stock does not move up (in case of a bullish trade), nor does it move significantly down with 2-3 days. We can exit with 2-3 sessions time stop loss and may lose negligible amount (15-20 percent of tiny premium that is paid).

Thus, if we find big tensions especially during the 1st half of the expiry, we can use Ratio Back Spreads to keep our cost very low and benefit from a directional move.

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